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FDIC Center for Financial Research Working Paper No. 2009-06

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FDIC Center for Financial Research Working Paper No. 2009-06 Sanjiv R. Das FDIC Center for Financial Research Darrell Duffie Working Paper Nikunj Kapadia No. 2009-06 Empirical Comparisons and Implied Recovery Rates Bank Failures and the Cost of Systemic Risk Risk-Based Capital Standards, Deposit Insurance and Procyclicality kkk April 2009 Risk-Based Capital Standards, Deposit Insurance and Procyclicality An Empirical September 2005 An Empirical Analysis Federal Dposit Insurance Corporation •Center for Financial Researchh State- May, 2005 Efraim Benmel Efraim Benmelech June 20 May , 2005 Asset S2005-14 Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930* Paul H. Kupiec and Carlos D. Ramireza April 2009 Keywords: bank failures; systemic risk; financial accelerator, vector autoregressions; Panic of 1907; non-bank commercial failures JEL Classification Codes: N11, N21, E44, E32 * The views and opinions expressed here are those of the authors and do not necessarily reflect those of the Federal Deposit Insurance Corporation. We are grateful to Mark Flannery, Ed Kane, Thomas Philippon, Peter Praet, Lee Davidson, and Vivian Hwa for comments and suggestions. Ramirez acknowledges financial support from the FDIC’s Center for Financial Research. a Carlos Ramirez is Associate Professor, Department of Economics, George Mason University, and Visiting Fellow, Center for Financial Research, FDIC. Email: [email protected] . Paul Kupiec is an economist at the FDIC. Email: [email protected] . Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930 Abstract: This paper investigates the effect of bank failures on economic growth using data from 1900 to 1930, a period that predates active government stabilization policies and includes periods of banking system distress that are not coincident with recessions. Using both VAR and a difference-in-difference methodology that exploits the reactions of the New York and Connecticut economies to the Panic of 1907, we estimate the effect of bank failures on economic activity. The results indicate that bank failures reduce subsequent economic growth. Over this period, a 0.14 percent (1 standard deviation) increase from the mean value of the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real GNP growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as an important component of the cost of systemic risk in the banking sector. Keywords: bank failures; systemic risk; financial accelerator, vector autoregressions; Panic of 1907; non-bank commercial failures JEL Classification Codes: N11, N21, E44, E32 - 2 - I. Introduction Do bank failures create negative externalities that reduce economic growth? These externalities, should they exist, are a manifestation of financial sector systemic risk. Banks are a source of systemic risk if the social cost of a bank failure exceeds the direct losses to the claim holders of the failing bank. One potentially important component of this social cost is the subsequent loss in output associated with a bank failure.1 The failure of any firm will create externalities and losses in output, but because of their importance in the intermediation process, the costs and externalities associated with a bank failure are likely to be much larger than those created by the failure of a commercial non-bank entity. But how important are the negative externalities associated with bank failures? What is the cost of systemic risk in the banking sector? While scholars have studied the issue for more than 100 years and central banks increasingly are focused on the identification and reduction of financial sector systemic risks, surprisingly, there are no published measures of the cost of systemic risk and no academic consensus on the magnitude of the effect that bank failures have on subsequent economic growth. The modern literature on bank failures and economic activity is focused on two periods: the Great Depression (1930–1933) and the U.S. savings and loan and banking crises of the late 1980s and early 1990s (S&L crisis). There is consensus that a breakdown in the banking system intensified the Great Depression in the U.S., but Depression-era evidence from other countries as well as evidence from the S&L crisis is 1 Recent papers on bank systemic risk focus on the strength of correlation among bank defaults and mechanisms that can propagate shocks among banks or other financial institutions. Kaufman and Scott (2003) and Schwartz (2008) provide overviews of the literature. A common feature of all discussions of systemic risk is the existence of a mechanism whereby losses to one institution create losses for many other institutions. Few if any of these models directly discuss the real economic effects of systemic risk. - 3 - ambiguous. For example, the Canadian experience during the Great Depression does not suggest that there are large negative externalities associated with bank failures (Haubrich, 1990; White, 1984). Analysis of data from the S&L crisis has also produced conflicting results (see, inter alia, Ashcraft, 2005; Alton, Gilbert, and Kochin, 1989; or Clair and O’Driscoll, 1994). This paper investigates the effect of bank failures on economic activity using data from 1900 to 1930. Prior to the enactment of federal deposit insurance legislation in 1933, the United States experienced repeated banking panics, many of which occurred when economic conditions were quiescent. While many banks failed or temporarily suspended redemptions during banking panics, many of these banking panics were not caused by deteriorating macro-economic conditions.2 Another important feature is the lack of federal government institutions or policies to counteract the effects of bank failures and exert a stabilizing influence on economic growth. We will argue that these two important characteristics of this sample period and the use of new data for measuring banking system distress allow us to extract more accurate estimates of the economic costs of bank failures relative to estimates derived from other historical data periods. In the analysis that follows, we use vector auto regression analysis (VAR) to estimate the effect of bank failures on the volatility of industrial production and aggregate output growth. Bank failures are measured using newly constructed data on the share of banking system liabilities (predominantly deposits) in failed banks and trusts including 2 Calomiris and Mason (1997) provide evidence against the hypothesis that asymmetric information in banking panics is a separate source of bank failure. They study banks that failed during the 1932 banking panic and conclude that failed banks were financially weak and would likely have failed under non-panic conditions as well. Carlson (2008) takes issue with these conclusions and instead finds that there is a high probability that many of the banks that failed in 1932 would have been acquired, merged or recapitalized in a non-panic period. - 4 - both state- and nationally-chartered institutions. We argue that the data are consistent with the hypothesis that bank failures create negative externalities if: (i) bank failures on average reduce subsequent economic growth; and, (ii) on average, poor economic growth is not followed by a higher incidence of bank failure. We use Granger causality tests to establish that an increase in the liabilities of failed banks, other things equal, will reduce industrial production and economic growth, but a reduction in economic growth or industrial production need not lead to an increase in failed-bank liabilities. Our estimates suggest that, over the period 1900–1930, the variation in failed- bank liabilities explains about 8 percent of the volatility in output growth. Other things held constant, a one standard deviation shock to the share of liabilities in failed banks (an increase of 14 basis points over the mean value of the series) results in a cumulative 17 percent decline in industrial production (IP) and a cumulative 4 percent decline in GNP over the following three quarters. While the estimated effects of bank failures on economic activity may appear to be incredibly large, the ―small-shock large-cycle‖ phenomenon is well-known in the financial accelerator literature (Bernanke, Gertler and Gilchrist (1996)) and studies that document linkages between the financial sector and the macro economy. Moreover, the estimated effects from the VAR model are consistent with the historical record. There are only 7 quarters in sample period in which the share of liabilities in failed banks exceeded 21 basis points (the mean value plus the shock) and many of these episodes are associated with a significant recession.3 3 During the recession of 1907-08, real GNP posted a cumulative decline of 12.8 percent while IP fell by 31.7 percent. The recession of 1923-24 produced a cumulative drop of 3.1 percent in real GNP and 34.7 percent in IP. The large increase in the liabilities of failed banks in 1930 was associated with a 1-year drop of 4.7 percent in real GNP and 18.2 percent in IP. - 5 - We provide additional evidence on the link between bank failures and economic growth by comparing the economic performance of New York and Connecticut following the Panic of 1907. A year prior to the panic, business conditions in New York and Connecticut were similar to business conditions in the rest of the country and neither state had problems in their banking sectors. The 1907 banking panic resulted in important financial institution failures in New York, but none in Connecticut. At the height of the banking panic, economic conditions deteriorated substantially in New York and continued to deteriorate for another quarter as commercial failures mounted. In contrast, business conditions in Connecticut remained stable throughout the period. When economic performance is measured by time series data on the liabilities of non-financial commercial enterprise failures in each state, a formal difference-in-difference analysis supports the hypothesis that bank failures depress economic growth.
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